Voluntary Pension System (VPS)


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  • The Voluntary Pension System is a self-contributory pensions savings scheme Although self-contributory, there is no restriction on the employer to join in and contribute to its employees pension For a particular individual a limit has been set at PkR 500,000 as the maximum amount of contribution in one year Some relaxation on this rule for participants joining the pension plan after the age of 41 who shall be allowed an additional contribution of 2% p.a., provided that the total contribution does not exceed 50% of the individual’s total taxable income Although, this rule helps to keep a check on exploitation of the tax exemptions by the participants, it hinders the freedom of investing large amounts especially to individuals receiving inheritances, gifts etc in a particular year. Such individuals will have to seek alternate investment opportunities, which may be less attractive, especially from an after-tax return point of view
  • VPS will be a parent fund with three sub-funds namely equity, debt and money-market sub funds. Additional classes such as real estate and international investments may be added later The participants’ wealth/assets will be allocated as per their return objectives and levels of risk aversion
  • The Very Conservative plan allocates the investment between the debt and money-markets (minimum 40% in each class) with no exposure in equities The Aggressive plan invests a maximum of 80% in equities with the rest going to the debt and money markets. Similarly other asset allocation schemes (at least two more) may be offered by the pension fund manager Ideally, each investor’s level of risk aversion should be judged by the pension fund manager before assigning him/her to an asset allocation scheme Then, while staying within the asset allocation limits of a particular scheme, the allocation may be tilted as per the requirements and/or goals of the investor
  • PFM to choose percentage of contributions to go into each sub-fund for individual allocation schemes Percentages not to change more than once in a calendar year Participant to select any one of the allocation schemes offered by PFM If participant fails to make a choice PFM to allocate to either the Conservative or Very Conservative scheme
  • As shown, PkR 8,000 will be utilized to purchase units of the equity sub-fund at the prevailing price (i.e. NAV plus sales load), and PkR 2,000 will be used to purchase units of the debt sub-fund while no units of the money-market sub-fund will be purchased
  • - Particular asset classes may be generating comparatively lower risk-adjusted returns over certain periods of time. For example, in a low interest rate environment even riskier bonds may generate low returns
  • The proposed structure with sub-funds and investment restrictions within each fund is such that the investment policy is being defined before evaluating the individual investor’s objectives and constraints Investment policy inherently provides no product differentiation opportunity for the fund managers. Thus it reduces the incentives for fund managers to cater to a particular market niche The competitive environment with all PFMs following the same investment objectives and risk/return characteristics would lead to higher marketing and administrative costs with virtually no advantage to individuals seeking innovative products
  • It is a common global practice among asset managers that before opening any new investment account, the goals and constraints of the investor are analyzed and an investment policy is formulated Investors are provided with an appraisal form that evaluates the willingness and ability of the investor to take risk. The rule of thumb is to go by the investor’s willingness to take risk, unless the ability is less the willingness The VPS rules do not make any such provision that requires the asset manager to evaluate the level of risk aversion in relation to the investor’s return objectives The rules allow the investor to make the decision. No formalized process to determine such attributes of the investor is being implemented. In case the investor does not make a decision, the asset manager may invest in either the Conservative or Very Conservative allocation schemes. However, in this situation the investment account may not maximize the investor’s utility
  • While investors may make a decision, their decision may not be in line with their risk aversion level. It is sometimes very difficult for even veterans to determine risk of particular investments, let alone amateur investors looking to save up for retired life An analysis of the individual’s risk/return objectives would provide a guideline to the investment manager of the investor’s level of risk aversion and can thereby specify a plan The asset manager must evaluate a level of risk aversion and only then make recommendations to the investor
  • In developed nations such as US, EU, Canada, Finland and Japan, along with many developing countries, the Prudent Person Rule governs the actions of the asset managers in carrying out their duties However, nowadays, due to certain unnecessary limitations of the Prudent Person Rule, the new Prudent Investor Rule has started to take its place
  • The 5% allocation restriction in listed securities of one company is too restrictive. It should be at least 10%. It poses liquidity constraints and limits the choice of the fund manager to invest reasonable amounts in scrips providing competitive returns In addition, considering the environment in the KSE, only a small percentage of listed stocks are actively traded. The lack of liquid stocks on the market should be considered and thereby, the limit to invest in a particular scrip be increased
  • Voluntary Pension System (VPS)

    1. 1. Voluntary Pension System (VPS) A critique on the Investment Policy Najam Ali CEO ABAMCO Limited
    2. 2. Presentation Overview <ul><li>VPS Structure </li></ul><ul><ul><li>Sub-Funds </li></ul></ul><ul><li>VPS Asset Allocation </li></ul><ul><ul><li>Investment Process </li></ul></ul><ul><ul><li>Critique on Asset Allocation Requirements </li></ul></ul><ul><ul><li>Investor Goals and Constraints </li></ul></ul><ul><ul><li>International Comparison </li></ul></ul><ul><ul><ul><li>Prudent Person Rule versus New Prudent Investor Rule </li></ul></ul></ul><ul><ul><ul><li>Qualitative versus Quantitative Diversification </li></ul></ul></ul><ul><li>VPS Investment Limits </li></ul><ul><ul><li>Critique on regulations </li></ul></ul><ul><li>VPS – A long way to go </li></ul>
    3. 3. VPS – The Structure <ul><li>The Voluntary Pension System – a self-contributory pensions savings scheme </li></ul><ul><li>No restriction on the employer to join in and contribute to its employees pension </li></ul><ul><li>Max contribution limit of PkR 500,000 p.a. by any individual </li></ul><ul><li>Relaxation for participants joining the pension plan after the age of 41 </li></ul><ul><ul><li>Allowed an additional contribution of 2% p.a. </li></ul></ul><ul><ul><li>Total contribution must not exceed 50% of the individual’s total taxable income </li></ul></ul>
    4. 4. VPS – Sub-Funds <ul><li>VPS – a scheme with three sub-funds: </li></ul><ul><ul><li>Equity Sub-Fund </li></ul></ul><ul><ul><li>Debt Sub-Fund </li></ul></ul><ul><ul><li>Money-market Sub-Fund </li></ul></ul><ul><ul><li>Additional classes such as real estate and international investments may be added later </li></ul></ul><ul><li>Asset allocation as per participant’s return objectives and levels of risk aversion </li></ul>VPS – The Pooled Fund Equity Sub-Fund Debt Sub-Fund Money-Market Sub-Fund
    5. 5. VPS – Asset Allocation <ul><li>Pension fund managers (PFMs) to invest with: </li></ul><ul><ul><li>Transparency </li></ul></ul><ul><ul><li>Efficacy </li></ul></ul><ul><ul><li>Prudence </li></ul></ul><ul><ul><li>Soundness </li></ul></ul><ul><li>PFMs to offer at least 4 pre-set asset allocation schemes: </li></ul>40%-60% Nil 40%-60% Very Conservative 15%-30% 10%-25% 60%-75% Conservative 10%-25% 35%-50% 40%-55% Balanced Nil 65%-80% 20%-35% Aggressive Money Market Sub-Fund Equity Sub-Fund Debt Sub-Fund Allocation Scheme
    6. 6. VPS – Investment Process of an IPA Part 1: Formation of an Investment Policy Yes PFM assigns investor to Conservative or Very Conservative scheme Participant chooses asset allocation scheme, e.g. Aggressive PFM chooses percentage of contributions to go in each sub-fund, e.g. Equity: 80%, Debt: 20%, MM: 0% No REGULATION: Percentages not to change more than once in a given calendar year
    7. 7. VPS – Investment Process of an IPA Part 2: Monthly Fund Flow Investor PMF Trustee Equity Debt MM PkR 10,000 PkR 2,000 PkR 0 PkR 8,000
    8. 8. VPS – Critique on Asset Allocation <ul><li>Potential inefficiencies due to overly structured asset allocation: </li></ul><ul><ul><li>Structured asset allocation schemes may not be applicable to all investors </li></ul></ul><ul><ul><li>An individual’s position in a defined asset allocation scheme may hamper his/her investments from growing at competitive and efficient rates </li></ul></ul><ul><ul><li>Limitation of only one change per year in the percentage of contribution to each sub-fund is too restrictive as investor preferences, abilities and characteristics are dynamic – so should the asset allocation </li></ul></ul><ul><li>Recommendations: </li></ul><ul><ul><li>The limit on rebalancing and switching between investment classes should be increased to twice a year </li></ul></ul><ul><ul><li>Rather than defined allocation schemes, each IPA’s investment policy should be in accordance with the participant’s characteristics </li></ul></ul><ul><ul><li>Investors should have the flexibility to invest any fraction in a particular class for example 100% in equities </li></ul></ul>
    9. 9. VPS – Critique on Asset Allocation <ul><li>Recommendations (cont.): </li></ul><ul><ul><li>Investments should be made on principles of diversification, maximizing returns to participants and limiting risk </li></ul></ul><ul><ul><li>Investor’s objectives and constraints should be evaluated before formulating the investment policy (unlike predetermined allocation) </li></ul></ul><ul><ul><li>Product differentiation should be encouraged; else </li></ul></ul><ul><ul><ul><li>All PFMs follow similar investment objectives </li></ul></ul></ul><ul><ul><ul><li>Higher marketing and administrative costs </li></ul></ul></ul><ul><ul><li>Investment managers should be given more autonomy and flexibility to evaluate an investor’s risk level and use their prudent judgment in devising the optimal investment policy </li></ul></ul>
    10. 10. VPS – Investor Goals & Constraints <ul><li>A common global practice: To evaluate investor goals and constraints before formulating an investment policy – a law in UK </li></ul><ul><ul><li>Appraisal forms to judge the willingness and ability of the investor to take risk </li></ul></ul><ul><ul><li>Rule of thumb: Go by the willingness to take risk, unless the ability is less than the willingness </li></ul></ul><ul><ul><li>Asset Managers (are sometimes required by law) to only offer those investment opportunities to the investor, which are in line with their risk aversion level </li></ul></ul><ul><li>Fallbacks in the VPS Rules: </li></ul><ul><ul><li>No requirement to evaluate investor objectives </li></ul></ul><ul><ul><li>Allows investors to make decision and choose scheme </li></ul></ul><ul><ul><li>Or if no decision by investor – assign to Conservative or Very Conservative scheme – possibly inefficient </li></ul></ul><ul><ul><li>May not maximize investor’s utility </li></ul></ul>
    11. 11. VPS – Investor Goals & Constraints <ul><li>Recommendations: </li></ul><ul><ul><li>The investment policy (IP) should not be pre-formulated </li></ul></ul><ul><ul><li>Choosing a scheme on an ad-hoc basis should not be completely in hands of the investor </li></ul></ul><ul><ul><li>In line with international standards, the IP should be determined after thorough analysis of the investor’s attributes </li></ul></ul><ul><ul><li>Level of risk aversion must be determined by asset manager before offering an allocation style </li></ul></ul><ul><ul><ul><li>An institutionalized criteria of assessing investors’ level of risk aversion, such as that in Canada, should be introduced </li></ul></ul></ul><ul><ul><ul><li>PFMs should require investor’s to fill and sign risk assessment forms in order to determine the level of risk </li></ul></ul></ul><ul><ul><ul><li>Specialized software may be used for this purpose </li></ul></ul></ul><ul><ul><li>PFM must clearly explain the risk/return characteristics of a plan to the investor </li></ul></ul>
    12. 12. VPS – International Comparison <ul><li>The Prudent Person Rule </li></ul><ul><ul><li>Governs the actions of the asset managers in developed nations such as US, EU, Canada, Finland and Japan, along with many developing countries </li></ul></ul><ul><ul><li>Charges fiduciaries with conducting themselves with the same degree of judgment, reasonableness and prudence in administering the affairs of their clients, as they would in their own personal affairs </li></ul></ul><ul><li>The New Prudent Investor Rule </li></ul><ul><ul><li>Replacing the old rule due to certain unnecessary limitations </li></ul></ul><ul><ul><li>When dealing in their clients’ affairs, the new rule calls on asset managers to “observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested&quot; </li></ul></ul><ul><ul><li>Calls for diversification, capital growth and safety, and implementation of investment decisions in the context of the whole portfolio </li></ul></ul><ul><li>Such rules should also govern the actions of investment managers in Pakistan in order to gear the investment process to the benefit of the participants </li></ul>
    13. 13. VPS – International Comparison <ul><li>Two investment regulation approaches </li></ul><ul><ul><li>Qualitative </li></ul></ul><ul><ul><li>Quantitative </li></ul></ul><ul><li>Qualitative </li></ul><ul><ul><li>A prudent approach urging diversification </li></ul></ul><ul><ul><li>No defined investment limits </li></ul></ul><ul><ul><li>Followed in US, UK, Netherlands and Australia </li></ul></ul><ul><li>Quantitative </li></ul><ul><ul><li>Another prudent approach geared toward diversification </li></ul></ul><ul><ul><li>Provides clear cut limits on asset allocation and investment avenues </li></ul></ul><ul><ul><li>Followed in EU, Canada, India, Philippines and now in Pakistan </li></ul></ul>
    14. 14. VPS – Qualitative Approach <ul><li>Features: </li></ul><ul><li>Diversification requirement is stated as general principle </li></ul><ul><li>UK explicitly requires fiduciaries to develop a statement of investment policy to guide decisions </li></ul><ul><li>US requires no explicit point in this rule </li></ul><ul><li>Perspective in Pakistan </li></ul><ul><li>Market too regulated to have qualitative approach </li></ul><ul><li>Qualitative approach suits free markets </li></ul><ul><ul><li>Too many groups in small market constraints the ideal free market </li></ul></ul><ul><li>In essence, Qualitative approach is not appropriate for Pakistan </li></ul>
    15. 15. VPS – Quantitative Approach <ul><li>Main Feature: </li></ul><ul><ul><li>Imposes quantitative limits related to diversification </li></ul></ul><ul><li>Examples </li></ul><ul><ul><li>Canada 5% in Real Estate Investment of funds portfolio 30% in foreign investment of funds portfolio </li></ul></ul><ul><ul><li>Italy 15% in single investment of funds portfolio </li></ul></ul><ul><ul><li>EU 30% cap on investments in unregulated markets 5% cap on investment in a particular scrip 10% cap on investment in scrips issued by a particular group </li></ul></ul><ul><ul><li>Philippines 25% cap on investments in equities 25% cap on investments in real estate 10% of maximum allowable investment in a single asset </li></ul></ul>
    16. 16. VPS – Investment Limits <ul><li>Equity Sub-Fund </li></ul><ul><ul><li>5% cap on investment in shares of a company, 20% in a sector </li></ul></ul><ul><ul><li>1% cap on investment in any one green field company </li></ul></ul><ul><ul><li>Total investment in green fields not more than 5% of NAV </li></ul></ul><ul><ul><li>Investment in shares of only those listed companies that have an operational history of 5 years </li></ul></ul><ul><li>Proposed amendments: </li></ul><ul><ul><li>Green field projects must be clearly defined. Is a green field </li></ul></ul><ul><ul><ul><li>An IPO, or </li></ul></ul></ul><ul><ul><ul><li>A newly established venture? </li></ul></ul></ul><ul><ul><li>Restriction of investment in issues of companies with less than 5 years of operational history hampers prospects to reap gains from certain excellent growth opportunities </li></ul></ul><ul><ul><li>Some restrictions should be imposed to ensure liquidity of funds e.g. India’s proposal of PFs only investing in index shares </li></ul></ul>
    17. 17. VPS – Investment Limits <ul><li>Debt Sub Fund </li></ul><ul><ul><li>Debt sub fund consist of tradable securities with weighted average duration of less than 10 years </li></ul></ul><ul><ul><li>At least 50% of the assets will be invested in federal government securities </li></ul></ul><ul><li>Proposed amendments to overly restrictive regulations </li></ul><ul><ul><li>Duration term should not be restricted as investors with long term investment horizon (purpose of pension investment) will not be able to gain from high yield long term investments </li></ul></ul><ul><ul><li>Minimum 50% investment in government securities would mean high credit quality but low returns </li></ul></ul><ul><ul><li>Such restrictions carry no international significance especially in Pakistan’s emerging corporate bond market </li></ul></ul>
    18. 18. VPS – Investment Limits <ul><li>Money Market Sub Fund </li></ul><ul><ul><li>Weighted average duration of the fund should not exceed one year </li></ul></ul><ul><ul><li>No restriction on investment in government securities </li></ul></ul><ul><ul><li>All other securities capped at 20% </li></ul></ul><ul><li>Close to retirement a participant would be most heavily invested in the money market considering its safe and short term nature </li></ul>
    19. 19. VPS – A long way to go <ul><li>The VPS is yet in its infancy. Nevertheless, it is a much needed product and is the call of the time </li></ul><ul><li>As individuals become more and more independent and living standards increase, saving up for retired life is the rational way to go </li></ul><ul><li>The success of the system will be dependent on its adaptability to the joint-family system and demographics of the Pakistani society </li></ul><ul><li>Awareness and education about the benefits of pension plans will be necessary for the VPS to gain widespread acceptance </li></ul><ul><li>Following the examples of developed and other developing nations the VPS can be implemented in Pakistan. The product will be a success as long as it offers flexibility and ease to the investors to save up for their retired life </li></ul>
    20. 20. <ul><li>Thank You! </li></ul>